There is now an extensive literature on policy credibility, credibility being defined as the expectation that an announced policy will be carried out. Much of this literature has emphasized the role of a government’s “type” (for example, the relative weights it puts on the losses from inflation versus unemployment) in determining the credibility of a policy. When a policymaker delivers on an announced commitment to low inflation, this strengthens the belief that he really is inflation averse. Hence, a government that follows tough policies will see its reputation and the credibility of its commitment to anti-inflationary policies increase over time.
Whether or not an announced policy is carried out, however, reflects more than the policymaker’s intentions. The external situation can be as important. Because even a “tough” policymaker cannot ignore the cost of very high unemployment, he may renege on an anti-inflation commitment in sufficiently adverse circumstances, that is, in times of weak activity when pressures to restore high employment are strong. In short, the credibility the public assigns to an announced policy should therefore reflect external circumstances as well.
In assessing the effect of observed policy choices on credibility, the role of external circumstances may be especially important when policies have persistent effects on the economic environment. The purpose of this paper is to investigate the effect of such persistence and to demonstrate that if tough policies constrain the room for manoeuver in the future, then following a tough policy may actually harm rather than enhance credibility. For example, a tough anti-inflation policy today may raise unemployment well into the future, making the commitment to future anti-inflation policy less credible.
The effect of unemployment on credibility in France, using interest differentials relative to Germany as a measure of the perceived credibility of a country’s pledge to maintain a fixed parity in the EMS, supports this alternative view. In fact, though there was some weak evidence of the signalling role of unemployment in a period in the mid-1980s in which the priorities of the authorities had changed, in the earlier and later subperiods there seems to be clear evidence of a negative association between credibility and the unemployment rate. This suggests that both a policymaker’s reputation for pursuing a hard-currency peg and durably lower unemployment are necessary to convince investors of policy credibility. The results are far from conclusive, but they indicate that modeling credibility solely in terms of a policymaker’s preferences or intentions is seriously incomplete.